How Microsoft could make a $199 Surface RT a reality, and why it shouldn’t

An anonymous source has told Engadget that Microsoft's ARM tablet, the Surface RT, will cost just $199 when it goes on sale on October 26th.

Cue much incredulity from the rest of the Internet. $199 would be cheap for a 10" tablet with 32GB flash storage even if it were some plastic horror. Add in Surface's VaporMg finish, tight building tolerances, and Touch Cover keyboards, and the bill of materials is sure to be more than $199, and as such, Microsoft would be taking a loss on every unit sold.

Still, Microsoft could afford to sell Surface RT for $199. There are reasons why it might want to do so, and there are even realistic ways in which it could make up for that loss. But the negative effects of such a price plan would be enormous.

It goes without saying that Microsoft could afford to simply lose money on every Surface RT it sells. The company has enormously deep pockets. There is an obvious reason why it might want to sell the tablet for a loss, too. The market for touch-first, Windows 8-style (formerly "Metro-style") applications is currently zero, and Microsoft needs to change that, and fast, to stimulate application development. At $199, the tablet would be cheap enough that buyers might be willing to take a gamble and buy into the platform even without a proven application ecosystem.

There has also been some speculation that the $199 price isn't quite the whole story. Tim Stevens, who wrote the Engadget post, said that he had received multiple sources for the price, but that the situation was "complicated" in some way.

One possibility is that the hardware will be subsidized somehow. Giving expensive hardware a low cost of entry is standard practice in the cellphone industry, with carriers subsidizing handsets to the tune of hundreds of dollars, in return for two-year contracts typically worth a couple of thousand dollars. However, this route isn't open to Surface RT, as it will apparently lack 3G/4G connectivity.

Microsoft has recently started to sell Xbox 360s with an explicit subsidy. $99 up front, followed by 24 months at $15 a month, gets you an Xbox 360, a Kinect, and two years of Xbox Live Gold subscription. And of course, even without this arrangement, the console was sold for much of its life at below cost, with Microsoft hoping to recoup the difference through a combination of Xbox Live subscriptions and the percentage it takes from game purchases.

For Surface RT, one would expect the bundle to be different—perhaps two years of Zune/Xbox music and video for $20/month, say—but the idea is at least feasible. The US cellphone industry has demonstrated that you can charge through the nose for a contract just as long as the up-front cost is low enough, so such an approach can't be dismissed out of hand. Sure, it might cost you $679 over the life of the contract, but everyone will talk about it as if it were a $199 tablet.

Microsoft is also taking a cut of all sales on the Windows Store. If the company is truly confident that not only will the store thrive, but that it will become a bustling marketplace of paid applications, it could take the long-term view that whatever it loses in the short-term will be recouped in the long-term.

Just because you can doesn't mean you should

Using a $199 Surface RT to prime the pump would be valuable, and could probably be done without taking a massive loss. Nonetheless, it would seem to be a terrible idea. The downsides are numerous.

Microsoft's relationships with OEMs are already strained as a result of Surface. Acer, in particular, has been vocal in its complaints about Microsoft muscling in on the hardware market. A $199 system would give the company's hardware partners no room to maneuver, forcing them out of the Windows RT market as soon as they've entered it.

This would seriously harm relationships with the other OEMs. Digitimes reported that Acer CEO JT Wang was quite explicit on this point: it claims that he said that a $199 Surface RT would have a "significant impact" on the OEMs, but that a $499-599 price would have only a small effect. With no means to effectively compete with Microsoft, other tablet manufacturers would likely switch to, or stick with, Android.

That would be problematic for Redmond. As much as the company may be disappointed with the OEMs, the fact is, it needs them. Microsoft is a newcomer to the PC hardware market, and as such, it doesn't have the supply chain and manufacturing infrastructure to crank out tens of millions, or even hundreds of millions, of Windows RT tablets a year.

Even if the long-term ambition is to be an Apple-like vertically integrated system builder—and the profitability of this approach is certainly enviable—it will take years to build the experience and industry connections to do that. In the meantime, Microsoft needs the OEMs to be active participants in the tablet market.

Bad blood in tablets could have a knock-on effect on the desktop and laptop market, too. Windows 8 is already a contentious release thanks to its numerous user interface changes. It's not likely that the OEMs are going to switch to Linux anytime soon for their conventional PCs—but they could respond to doubts about the new operating system, especially among enterprise customers, by continuing to push Windows 7 even once Windows 8 has been released, and fueling the perception that Windows 8 just isn't cut out for conventional computers.

If the ill feeling is strong enough, then even lawsuits aren't out of the question. There could be an antitrust angle—Microsoft is rumored to be charging OEMs as much as $85 for Windows RT licenses, compared to, effectively, $0 for Surface RT—and possibly, if Microsoft sells Surface RT outside the US, a dumping angle—generally selling in foreign markets at below cost to hurt competitors is frowned upon. Selling Surface RT hardware profitably, and with enough margin to "pay" for the software license, would protect against such retaliation.

But perhaps the most significant reason of all not to price Surface RT at $199 is that once that decision is made, there's no going back. The price of a 10" Windows RT tablet will be two hundred bucks—or less—forever. Real (inflation-adjusted) computer prices have steadily trended downwards. OEMs have regarded the PC market as one that is commoditized and standardized, offering little ability to compete on intangibles such as quality and design, instead forcing competition on price alone. Schemes such as Intel's Ultrabook plan, which attempted to increase system prices and provide greater opportunity for smart design have had a lukewarm reception among OEMs, and have been undermined by a persistent tendency toward cutting corners in a bid to cut costs.

Tablets are unlikely to be able to buck this trend. While a $199 Surface RT would leave the door open to pricier devices sporting, for example, 13" screens, more internal storage, or 3G connectivity, it still doesn't leave much wriggle-room, and would yield no profit with which to fund future developments.

$199 is a crazy price for a well-built, well-designed, 10" tablet. It's not completely impossible, and there are ways in which the economics could be made to work. But the results for Microsoft and the PC OEMs alike would be nothing short of a disaster.